The macro-economic landscape of recent years, marked by rising interest rates and inflationary pressures, has significantly escalated borrowing costs in the European mid-market. This has prompted borrowers to explore alternative mechanisms within their credit agreements to alleviate the immediate cash burden of debt repayment. One such mechanism, that has increasingly gained traction, is the option to capitalise interest, commonly known as the “payment-in-kind” (PIK) toggle. PIK toggles offer borrowers the flexibility to add a portion of due interest to the loan principal instead of settling it in cash, thus reducing the immediate cash outflow.
This short practice note will examine the most negotiated features in PIK toggle provisions, including how much of the interest can be PIK’d (for example, the full interest rate or just the margin, the minimum cash payment requirements and the frequency the toggle can be used) along with the premium constructs that we most often see in the European mid-cap market. An overview of these considerations in local PIK regimes will conclude this note emphasising the need for a tailored approach that accounts for the jurisdictional nuances of the borrower and governing law.
Extent of Capitalisation – The pivotal question in structuring a PIK toggle is determining the portion of interest eligible for capitalisation. This can range from capitalising only the interest margin to including the entire interest payment (the latter affording a borrower to capitalise not only the margin, but also the base rate (EURIBOR, SONIA SOFR, etc.)). Although we have seen the more borrower-friendly construct of PIK’ing the full interest rate, the PIK toggle on the margin predominates the market. In addition, in many cases there remains a minimum portion of the margin that must be paid in cash – often between 3% and 4% per annum. Requiring a certain portion of the margin to be paid in cash helps to protect lenders from borrowers with low cashflows or in financial distress from accumulating large amounts of additional debt and imposing financial rigour that servicing a portion of the interest of the key debt in the structure must form a priority for the borrower. Certain credit funds are also leveraged themselves and require a portion of the interest to be paid in cash in order to service their own facilities.
Premium Structures – Since deferring a portion of an interest payment creates a credit risk for lenders, PIK toggles include a premium construct. Constructs seen in the market include: (i) a flat premium (e.g. a 25 basis points per annum increase to the margin), (ii) a cumulating premium of x basis points per 100 basis points of margin PIK’d (for example, 25 basis points per annum for each 100 basis points of margin converted into PIK margin) and (iii) a tiered premium construct, whereby a given flat premium applies if less than a certain percentage of the cash margin is PIK’d and a greater premium applies if more than such predefined percentage is being PIK’d (for example, 25 basis points per annum if PIK interest is equal to or less than 200 basis points and 50 basis points if PIK interest is greater than 200 basis points). And, of course, there is also an “interest on interest” effect of PIK: once a portion of the margin is PIK’d, that portion is added to the principal (and as such accrues interest). As a result, lenders receive compensation for the increased risk associated with this feature in two ways: the premium and the interest received in connection with the increased principal.
Conditions – The ability to exercise a PIK toggle is sometimes subject to compliance with certain conditions, most commonly there being no event of default continuing at the time of the election for a PIK toggle, or less commonly, the switching off of certain dividend baskets. The inclusion of such an “event of default blocker”, the aim of which is to prevent an increase on the risk profile of the credit at a time of distress, needs a particular focus to ensure the timing of the election operates in a way to allow the blocker to be used at an appropriate time (see further information on this below). Such a blocker can also be limited to a subset of particular material events of default in more borrower-friendly deals. Turning off dividend payments while interest is being PIK’d is a further consideration linked to risk profile, if the lenders’ return is being delayed, the shareholders should not simultaneously be taking value out of the structure. Occasionally, lenders also construct PIK toggles such that they can only be used when cashflows are tight.
Duration – An additional issue centres on the duration for which interest can be PIK’d. In certain cases, there is no restriction on this, and interest can be PIK’d for the life of the facilities. A more lender-friendly construct limits the number of interest periods during which interest can be PIK’d. In these cases, a common construct is to either limit the total number of months or financial quarters during which interest can be PIK’d (for example, a maximum of six quarters) or to limit both the total number of months or financial quarters as well as the number of consecutive months or quarters (for example, a maximum of six quarters, with no PIK toggle in consecutive quarters).
Jurisdictional Considerations – It is essential to underscore the impact of local jurisdictional nuances on PIK toggle provisions. These differences can notably influence the capitalisation frequency, the timing of PIK elections, and the requisite documentation for such elections. For example, in jurisdictions like France, Belgium, and Luxembourg, legal stipulations mandate that interest can only be capitalised annually to maintain the validity of PIK elections. Furthermore, both Belgian and Luxembourg law require a formal written agreement by the borrower post-PIK election, in addition to the provisions outlined in the credit agreement. It is also imperative to consider how various jurisdictions may view PIK interest differently, especially regarding taxation and usury laws, which can impose caps on interest rates. In cross-jurisdictional contexts, particularly in insolvency scenarios, the enforceability of interest capitalisation might be challenged, potentially affecting the classification of PIK interest as principal. Such intricacies highlight the necessity for careful legal scrutiny according to the borrower’s jurisdiction and the governing law of the agreement.
Prospective or Retroactive – Lastly, there are also negotiations around whether a PIK toggle must be exercised at the beginning of an interest period or whether it can have a retroactive effect and apply to the interest accrued during an expiring interest period. The timing of a PIK election is important here; the protection of an event of default blocker can be neutered if a borrower can elect to PIK for multiple interest periods in advance of seeing a potential event of default on the horizon. The key here is to only allow a PIK election to occur in respect of the then current interest period.
As noted above, PIK toggles have become increasingly prevalent in a macro-economic environment where borrowing costs have increased. And PIK toggles are less likely here to stay since in the near term it seems that interest rates are unlikely to return to levels seen during the early parts of the Covid-19 pandemic. They are a tool to be exercised wisely, since compounded interest can quickly escalate a company’s debt profile and erode equity returns, resulting in the feature potentially being a double-edged sword. Careful consideration and strategic use are paramount.
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